The true identity of the inventor of Bitcoin remains the subject of speculation among aficionados of the virtual currency. But one thing we know for sure is that Satoshi Nakamoto is an extremely clever person. Not only did he or she devise the unalterable algorithm that mints the currency automatically – an impressive feat of technological prowess. Nakamoto also understood something fundamental about money. Holding and using it involves a leap of faith.
Nonetheless, Nakamoto missed a crucial point. A good currency must hold its value over long periods. It must also be readily exchangeable for the goods and services that people actually want. Combining those two functions in a single instrument requires a delicate balance. If issuance is too tight, there is not enough money moving around to meet the payment needs of the economy. This can lead to deflation and recession. Yet if too much money is issued the result will be inflation, which erodes the currency’s value. This is the dilemma that “private money”, the creation of banks rather than government authorities, has never been able to solve. Nor have money regimes based on commodities, such as the gold standard.
To solve this problem, many countries have created independent central banks. The quantity of money that society needs changes constantly because of fluctuations in economic and financial activity. Human judgment is required to make sure that, when the economy grows, an adequate supply of money is maintained. But, crucially, central bankers have to be made independent. This guards against excessive expansions in the money supply – a permanent temptation in all political systems because it spreads economic cheer, but one that over time erodes the value of money.
Nakamoto thought he could solve the dilemma in a different way, with an inflexible rule. This could work, if the rule were a good one. Milton Friedman had a simple suggestion, arguing that the money supply should expand at a constant rate. That is a proposal on which someone of Nakamoto’s intellectual agility could no doubt have improved – for example, by increasing the rate of issuance as Bitcoin gained wider currency, or somehow making it sensitive to changing economic conditions. That could have given Bitcoin a chance of success.
But Nakamoto chose a different rule. The stock of Bitcoins – which currently stands at roughly 12m – will grow at a predetermined and gradually decreasing rate. Once there are 21m of the electronic tokens, new production will cease altogether.
This is a fatal mistake for two reasons. First, over the next century and a quarter, the supply of Bitcoins will increase on average by 0.6 per cent a year. If the Bitcoin economy grows faster than this, the currency will grow scarce and the prices of goods expressed in it will fall. Second, the supply of Bitcoins will expand more slowly than that of physical currencies. Other things being equal, its exchange rate will appreciate significantly.
This may be one reason why investors have pushed the price of Bitcoin to dizzying highs, with the result that it has become valuable even before it had the chance to establish itself as a means of payment. With real-world currencies such as sterling and the dollar it was the other way around: the currency became valuable because it was widely used as means of exchange.
Paradoxically, this rapid increase in the value of Bitcoin makes it unsuitable as a means of exchange. Someone who expects the currency to be worth more tomorrow will be unwilling to spend it today. And, if few people are spending Bitcoins, there is little incentive to accept them. There are no statistics available but one suspects that very few purchases of real goods are settled in Bitcoins.
The currency is at present attractive for two reasons. One is anonymity, which makes it suitable for tax evasion and money laundering. This will not last; authorities are already wising up. The other is pure speculation. Bitcoins are the tulips of modern times. The mania is not yet over. But the longer it lasts, the more investors are likely to be burnt.
The writer is professor of economics at SciencesPo and a former deputy governor of the Banque de France
